As any surfer will attest, success comes from knowing where to find the best waves and what size board to bring, given the season and the predicted conditions. That's analogy for government contractor exit strategies. While business owners can’t control the market, they can forecast trends and use the appropriate tools to ensure the best outcome.

The post 9/11 decade saw a boom in valuations and corresponding merger and acquisition activity, and we are now experiencing the overhang from this – with some combination of severe spending cuts in government contracting and increased taxes likely for the short and medium term.

This environment is challenging, but it should not necessarily force an owner to sell a company under less than ideal conditions or “wait it out” until the environment improves. There are other options.

One that we are structuring for many of our clients is an employee stock ownership plan, or ESOP, which directly addresses many of the challenges government contractors are facing. An ESOP is a qualified, defined contribution plan. In general terms, an ESOP is a way for a business owner to partially or fully sell shares in the company to employees and receive substantial benefits for doing so.

Indeed, ESOPs were a common structure for government contractors in the 1980s and 1990s. It was not until post 9/11 when valuations in the sector shot up that many contractors pursued mergers and acquisitions.

So why does exploring an ESOP make sense in current market conditions? First of all, an ESOP structure allows the owner to defer (potentially indefinitely) capital gains taxes on the transaction. The higher tax rates go in the short and medium term, the more valuable an ESOP option becomes. This also allows owners to time the market, subsequently liquidating their position if tax rates go back down.

A second consideration is valuation. Since an ESOP valuation is directly related to a bank’s ability to finance a transaction from existing cash flows and largely discounts any strategic premium, there has historically been a gap between ESOP valuations and an open market sale.

However, with declining capital market valuations but a relatively healthy bank lending environment for ESOPS with respect to leverage and interest rates, this gap is closing fast. For government contractors with a certain profile and large exposure to small business set-aside contracts, we are actually seeing ESOP valuations materially higher than comparable valuations from an M&A process.

Additionally, some buyers are seeking to “share the risk” of an uncertain contracting market by making a material portion of the purchase price contingent. Many sellers believe that if they are going to continue shouldering a substantial amount of the risk from the company going forward anyway, it may make sense to do this by continuing to hold some equity, retain some control and share this risk with the employees.

Beyond the economic arguments, there is some “option value” to an ESOP. An ESOP enables the owner to maintain some degree of control and determine exactly when the transaction occurs (without the risk of a buyer getting cold feet at the last minute, trying to re-trade on deal terms, etc).

Additionally, this could be a partial liquidity event, allowing owners to diversify their holdings with an eye on a sale after the company has grown further, won more prime or full and open contracts or is seeing improved market conditions.

Operationally, there could be benefits as well. To the extent that employees embrace this structure and begin to act like owners, there may be a positive impact on the bottom line, thus increasing the value of the shares for everyone involved.

There is an additional benefit for government contractors: Various components of the ESOP's cost can be passed through in their rates, which means having the government partially offset the cost.

Finally, customers tend to like this structure over a potential acquisition. Unlike the uncertainty surrounding how new ownership will affect a vendor’s performance and responsiveness, a structure that empowers employees is always well-received.

This is not to say that ESOPs are the right solution for all government contractors seeking liquidity. There are a number of considerations, including the administrative costs, the additional fiduciary responsibilities and others.

However, while M&A has been the obvious exit strategy for most our clients over the last decade, these days there is no “silver bullet” for the owners of government contractors seeking liquidity in this dynamic market.

Does it make sense to “backstop” a sale process with an ESOP to ensure a deal gets done? Should an owner structure an ESOP as a short-term plan to diversify holdings while implementing a set-aside contract transition plan within a longer term sale or initial public offering? A comprehensive exit strategy and process that utilizes all the tools available is more important than ever.

In these turbulent times, an elegant approach can go a long way to ensuring continued success of the company and maximize total value to its shareholders.

Mitchell Martin is a principal at The McLean Group, an investment bank based in McLean that provides merges and acquisition, business valuation and strategic consulting services to middle market businesses.